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The term ‘head and shoulders’ refers to a technical analysis chart pattern traders use to identify potential price reversals in an asset. The shape of the pattern resembles a head with two shoulders on either side, which is where it gets its name. It can be used when analysing price charts of various financial markets, such as stocks, forex, commodities, and more.
The pattern consist of three peaks, with the middle one (the head) higher than the other two of roughly the same height (the shoulders). To confirm the pattern, the trader can look out for the asset price breaking through the ‘neckline’, which can be identified by connecting the two shoulders.
The pattern forms when an asset reaches a new high, retreats, and rallies to a higher high. This forms the first two peaks – the first shoulder and the head. The asset then retreats again. To conclude the pattern, it rallies again, but it does not reach the price level of the highest point (the head). This forms the second shoulder.
When the pattern forms, traders can take advantage of the potential reversal by entering a short position and selling the asset once the price breaks through the neckline. To manage risk, they can then set a stop loss order above the right shoulder. Should the price break out of the pattern, the trader can still limit their losses.
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See related entries from our knowledge base:
The most common trend reversal patterns
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